Banks can notably increase their leverage ratios if they
consolidate their trading books into currency hubs, according
to TriOptima, a technology vendor.

Reorganizing their trading books into groups by currency
will allow banks to eliminate more trades in their compression
cycles, it says, making them stronger in the
eyes of regulators and freeing up capital they can use
elsewhere.

Peter Weibel,
triReduce

TriOptima’s compression service allows groups
of institutions to aggregate their trades and eliminate those
that offset each other. This is one way banks can improve their
leverage ratios – the relationship between their core
capital and total assets, which European regulators advise
should be at least 3%.

Portfolio compression enables counterparties to reduce the
gross notionals of their outstanding portfolios without
fundamentally changing their market positions.

Eligible trades for all the counterparties are aggregated so
any offsetting trades can be eliminated or replaced, while
maintaining risk neutrality. This enables counterparties to
reduce overall notional amounts, while enhancing capital
efficiency.

Peter Weibel, CEO of triReduce, TriOptima’s
compression service, says: "We are already seeing a trend
towards banks creating hubs of their trading books, through
which they channel their trades they wish to compress.

"Banks should be making every effort to continue with these
efforts because the smaller the book fragmentation, the more
efficient their compression results and the more beneficial it
will be for their leverage ratios."

In one recent cycle, 18 SwapClear members compressed 40% of
outstanding notional and 49% of outstanding trades in Polish
zloty interest-rate swaps and forward-rate agreements using
triReduce. The local and international participants eliminated
Z2.6 trillion ($654 billion) in the risk-constrained,
multilateral triReduce cycle for unlinked transactions.

Weibel says reducing over-the-counter (OTC) derivative
outstanding notional amounts is a substantial contributor to
achieving the leverage ratio goals of individual institutions
and to enhancing stability in the financial markets.

"The zloty market provides an interesting example of how
compression efficiency increases in a concentrated market," he
says.

"It is a similar story also for South African rand and
Mexican peso. This again demonstrates the great potential
compression has to reduce outstanding notional amounts,
particularly when there is little book fragmentation."

In the larger currency markets, such as dollars, euros, yen
and sterling, banks’ trading books are more
fragmented, which reduces the efficiency of compression.

However, Weibel says the zloty example illustrates the kind
of potential triReduce’s risk-constrained
compression could have across the trading book, if those
trading books were organized into hubs rather than being spread
across silos.

In some ways, the major currencies have even greater
potential for compression than the zloty, given their greater
liquidity.

Compression cycle

On average, there are around 20 to 30 participants in a
compression cycle, but there can be as many as 50 institutions
participating in those compressing larger currency trades. The
more institutions there are in a compression cycle, the more
chances there are for trades to be offset and the greater the
potential compression.

The multilateral compression service for OTC derivatives,
which was established in 2003, can be used in portfolios of
cleared and uncleared interest-rate products in 27 currencies,
credit default swaps, commodity swaps, inflation swaps, cross
currency swaps and FX forwards.

Currently, TriOptima delivers triReduce compression for
cleared trades in collaboration with clearing houses (CCPs)
around the globe, as well as to CLS members for FX forwards. It
expects to agree deals with more CCPs in coming months, as the
number of CCPs in Europe is projected to grow.

The challenge in the near-term is for banks to reorganize
their divisional structures and trading books to manage trades,
such as FX, centrally, which would allow them to more
efficiently compress trades using a service such as
TriOptima.

Banks are in different places in terms of the organization
of their trading books.

David Clark, chairman of the Wholesale Markets
Brokers’ Association, says: "Some banks have acute
cases of silo-itis – their businesses are scattered,
by geography or product – which makes it harder for
them to coordinate."

Many banks developed this silo structure in the days before
the financial crisis, when it made sense to book trades
off-balance sheet to reduce the capital costs associated with
these trades.

However, since 2008 it has become clear the capital costs of
treating trades in this way had been substantially
underestimated. The cost in terms of credit and market risk was
higher than the capital that had been set aside under the older
Basel rules, while the operational cost, arising from the fines
regulators imposed on some banks, was even greater.

Banks were also under considerable pressure to cut costs,
and many are now living with the consequences of the decisions
they took in the period after the financial crisis. Some banks
cut their IT budgets, which has made it difficult to execute
IT-intensive solutions to their problems, such as
compression.

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